The Fund Director's Role in an SEC Examination Print E-mail
Written by C. Meyrick Payne   

The purpose of this MPI Bulletin is to help mutual fund directors think through their responsibilities in connection with an SEC Examination. A panel of mutual fund experts, including an independent director and a representative from the SEC, convened under the auspices of Fund Directions to discuss this issue.

First and foremost, the new SEC Chairman, Harvey Pitt, has emphasized that the SEC is service organization, where there is no inherent virtue in playing "Gotch ya!" He has spoken eloquently about building a partnership with the accounting profession to cooperatively enforce the law and bring abnormalities to light. The panel concluded that the routine listing of inconsequential record keeping deficiencies would play a major part in future SEC examinations. On the other hand, substantive departures from sound business practices, particularly those that reflect veniality and disservice to public investors is not to be tolerated. The success of the mutual fund industry is, in large part, based on the confidence that investors have in the mutual fund industry.


The supplement is divided into three sections, which describe the directors' responsibilities:

In anticipation of an SEC examination: what a mutual fund director can do to get ready to ensure that SEC finds no deficiencies.

In relation to the actual content and conduct of the examination: what the director has to know about the content of an exam and the priorities of the new SEC Chairman.

For cleaning up and systematically correcting SEC comments: how the fund director can follow through to ensure that the SEC comments are acted upon and the systemic changes made to strengthen internal controls.
Each topic is discussed below.

In Anticipation of an SEC Examination

The SEC Division of Investment management aims to conduct regular inspections of each of the 7,500 managers and 1,100 mutual fund complexes every five years. This equates to about 225 complexes and 1,500 advisors each year. The investment managers manage about $20 trillion in assets or more than the entire US banking system, which includes separate accounts, pensions and trusts as well as mutual funds. The 1,100 fund complexes have over 8,000 funds with about $7 trillion in assets. Their task is enormous.

To do the job the SEC has 10 regional offices and about 350 examination personnel. Not many resources when compared to the federal, state and local banking regulators, who collectively have about 40,000 people. To leverage their work the SEC relies heavily on the active role of mutual fund directors.

The SEC normally schedules their routine examinations about two months in advance assuming they have no reason suspect malfeasance. The exception is that the first SEC visit to a complex or management company may well be unannounced. One of the first things the SEC does is to interview the CEO or a very senior executive. From this interview they gauge the "control environment" which impacts the extent and intensity of their examination.

Prior to beginning an examination, the SEC personnel will review the worksheets from prior examinations, all SEC filings, any press coverage about the fund or its manager, and the fund's website and advertising. The visit itself is normally conducted by 3 to 6 people depending on the size of the complex over a three to five week period.

The senior examiner, in accord with some general SEC guidance, determines the nature of the SEC work. These guidelines are intended to assure that inspections are consistent across the country. They focus on "risk-based" factors, such as the places where there may be conflict of interest or the application of judgment. Examples include the allocation of IPOs, allocations of cost between different businesses (separate accounts, hedge funds and mutual funds for example), personal trading, and the application of the code of ethics.

Lori Richards, head of the SEC's Office of Compliance, Inspections and Examinations, has stated that the "risk-based" inspections process involves asking oneself the following questions:

Is a system of internal controls in place and operating? A compliance or procedures manual gathering dust on a bookshelf will not serve anyone's interests.

Is the system working as designed? No matter how good your formal system may be, you should expect informal systems to spring up around it. Many of these ad-hoc methods are harmless. In fact, when you find them, some may be improvements over the formal system. In other instances, however, employees may circumvent important procedures in the interest of getting their work done more quickly or more easily.

Are exceptions and problems identified and resolved promptly? Of course, this is of critical importance. Once a potential problem is identified, prompt and effective resolution is the essence of compliance.

Is the system of controls reviewed periodically? Mergers, acquisitions, reorganizations, new staff and other changes necessitate that controls be frequently reviewed for continued effectiveness.
Paul Roye added three more procedural questions designed to help the SEC ascertain if the internal controls are adequately imbedded in the compliance process:

Are your procedures in writing and made available to all appropriate personnel?

Is all appropriate staff trained in implementing the procedures?

Are remedial actions fully documented? If SEC examiners cannot determine how a problem was corrected, they will question the effectiveness of the fund's controls.
The panel concurred with Paul Roye that:

"As directors of (mutual) funds, you must insist on an effective system of internal controls. You should insist that the management company acquire, and retain the talent, as well as the technological tools, that are more and more critical to a good internal controls infrastructure. Are you going to be associated with a fund group that cuts it close to the line or a firm that strives for the best compliance practices and controls?"
Prior to an SEC examination, a mutual fund director should be particularly familiar with any violations of the code of ethics, the corrective action taken and the systemic changes implemented. Included in this review should be at least one meeting with the top compliance executive employed by the management company. In addition, the fund directors should receive reports from the top compliance executives of any of the fund service providers, such as transfer agent, custodian and fund accountant.

Many investment managers retain the services of an accounting firm to perform a periodic dry run of an SEC examination. This is done both to get ready for a specific examination and to collect and organize the materials. The panel placed considerable importance with being as ready as possible for an SEC examination and avoiding, wherever possible, adverse comments.

Content of an SEC Examination

The SEC examiners will spend a great deal of time reviewing the Board and Committee minutes. These predicate many of their judgments about the board's oversight of the fund group. As such there is an advantage in having the minutes reflect all the issues with which the directors wrestle. On the other hand, some lawyers say that minutes should be sparse so as to eliminate any danger of later subpoena. In any case the directors should realize that the minutes provide the primary evidence of their application of informed business judgment.

About 10% of SEC examinations result in no comment. In which case the SEC writes to the manager to say the examination is closed. About 90% of SEC Examinations result in comment letters. The SEC is trying to use the term "comment letters" as opposed the formerly favored term "deficiency letter" as part of the new Chairman's emphasis on a friendly, but firm, regulatory environment. Similarly the SEC is trying a new process by which it will discuss its findings before the comment letter is issued. If the comment is relatively small and the management company implements corrective action immediately, the comment letter might well say that the weakness has already been corrected.

The panel believes that new attitude is an important development because, for the first time, the SEC will consider preventative and remedial actions taken by investment managers and funds involved in a violation of the securities laws when deciding to bring an enforcement action.

The comment letter is typically addressed to the President of the Fund, who is usually also the CEO of the management company. Only if the comments are very serious or involve a breakdown in governance, are they addressed to the independent directors directly. However the SEC expects that their comments be transmitted to the directors with a summary of what was done to correct any weaknesses found. In the event that the SEC has no comments, they will write within 90 days to say that the examination is closed.

The SEC comment letter requests that a response within 30 days, either agreeing with the findings and specifying a timeframe over which changes in procedure will be made, or disagrees and states why. Often the SEC will examine the procedures of a third party vendor, such as the transfer agent or custodian. To the extent that the SEC comments impact the business of a particular fund group, the SEC expects that the management company and usually the independent directors be informed.

The comments generally fall into three categories:

Fund service providers are out of compliance with the appropriate regulations or governing documents. These comments range from being very serious where there is or may be harm to the stockholders to innocuous where the comment is purely administrative.

Documentation is not current or incomplete. These comments are typical and not usually harmful to the shareholders, except where lapses in insider trading reporting occur.

There is weakness in internal control. The SEC regards these as serious because systemic problems can result and ongoing damage be done to shareholders.
If there are serious deficiencies, where the fund shareholders are likely to be harmed, the matter may be taken up by the Enforcement Division. In which case the SEC might bring a legal action against the fund, manager or service provider.

In terms of examination priorities, the SEC has publicly indicated that it will focus on the following topics. Each is discussed in turn.

Internal control; SEC examiners make a priority of looking for a strong system of internal controls evidenced by a clear audit trail. This priority, in the opinion of the panel, reflects the new SEC Chairman's reliance and belief in the value of the accounting profession. One of the items, an SEC examiner might request is the letter from the auditors to the president of the funds recommending improvements in internal control. The minutes of the audit committee are also likely to be requested.

Looking out for the interests of stockholders; the SEC expects to see a track record of fund directors paying attention to areas, such as fees and expenses, which significantly impact stockholders. Paul Roye, Director of the Division of Investment Management, emphasized in his 2001 speech at the ICI New Directors workshop that

"A 1% increase in a fund annual expense could reduce an investor's ending account balance after 20 years by 18%. He also emphasized that directors should have an understanding of the manner in which the fund's compliance program is structured and the nature of the internal controls system. This understanding is gained through regular reports and meetings with compliance personnel to discuss procedures and deficiencies. Directors should also discuss and review the adequacy of internal controls and procedures with the fund's accountants. Fund directors also need to understand the operational risks that arise in mutual fund operations, such as those arising from portfolio management, custody, pricing and technology. Breakdowns in compliance and internal controls can lead to major problems for the fund, which can undoubtedly complicate the life of an independent director."

Money laundering, to comply with the new terrorist legislation. The detection of the origination of money laundering schemes can be discovered in the examination of distributors or broker/dealers in connection with large cash deposits or transfers. The layering of money laundering, essentially the second stage of cleansing, may occur as money is moved from fund to fund or aggregated. The SEC is obliged to look for disturbing patterns or systematically weak controls.

Affiliated transactions, particularly where there could be conflict of interest between the fund shareholders and the management company or its affiliates. Perhaps the most conspicuous affiliated transaction is the annual renewal of the advisory contract. Almost always an SEC examiner will ask to see the minutes of the applicable board meeting and the documentation provided to the independent directors to support their decision.

Fee splits; of particular import to the commission are cases where there is a fee split. The SEC wants to see that the split is reasonable in relation to the actual work performed. Perhaps the most obvious example is where the advisory fee is split with a sub-advisor. Another example is the split of some part of an administrative fee to a third party provider. The SEC wants to see that the directors of a fund have applied sound business judgment to approving such an apportionment.

Fair value procedures. The SEC wants to know that the independent directors established the guidelines, that the process is followed and that the results are reasonable. Excellent evidence of a sound procedure is for the pricing Committee, if there is one, to maintain clear and accurate minutes.

Privacy, new legislation mandates that all non-public financial information of fund stockholders is kept confidential. The SEC wants to see that such a policy is in place and that the manager follows the law and guidelines set by the fund directors.

Disaster recovery, since the horror of September 11, 2001 disaster recovery plans have been high on the SEC agenda. Of particular import are plans for the preservation and backup of shareholder records and pricing/valuation data. The panel felt strongly that each director should have easy reference to the contact details for the other directors and key management company personnel.

Advertising. Directors should be aware of the process for creating and verifying advertisements. Clearly the directors cannot possibly look at every ad composed, but they certainly should be aware of the internal controls and verify that it is applied. The panel felt that independent directors should periodically spot check ads.

Independence of fellow directors, auditors and counsel; this was a major priority of former SEC Chairman Levitt and remains an important pillar of the oversight mechanism, particularly the selection of new independent directors by existing independent directors. But, in the opinion of the panel, the new Chairman Harvey Pitt has substituted the application of sound internal controls as his first priority.

Financial stability of the adviser; with the end of the bull market, the SEC has become more concerned that fund directors pay attention to the financial stability of the manager, particularly with regard to its ability to continue serving the needs of the fund shareholders. Another aspect, which sometimes concerns the SEC, is the ability of the manager to reimburse fund expenses where they have committed to do so. An uncollected receivable on the books of the fund is a unambiguous tip off to this situation.

"Best execution" of stock trades. With the increasing ease of affecting stock trades on electronic crossing networks (ECNs) the SEC is concerned that funds obtain "best execution". While the SEC makes no blanket policy that, say, 6 cents per share is too expensive, it does look to see if the directors apply sound business judgment when trades are allocated among brokers.

Soft dollar transactions; the SEC has long recognized the potential for the misuse of soft dollar credits which arise in the form of rebates from full service brokers. In particular the SEC wants to see that soft dollar credits are properly spent for research. The same considerations are applied to "directed brokerage", where any rebates are properly applied for the benefit of the fund's shareholders and not for the investment manager.

Code of ethics and insider trading; an SEC examiner will want to see the required code of ethics and understand the process by which it is enforced. He or she will also want to review any violations, which have occurred, and the corrective actions taken. In addition the examiner will want to see that the board has been informed of the violations.
There are also examples of topics where the SEC's priorities have decreased. Ten years ago the SEC was extremely concerned about derivatives and the credit worthiness of counter-parties. While these are still important, new technology and control systems have made these more manageable.

In Response to an SEC Comment Letter

Mutual fund directors have the ultimate responsibility for seeing that SEC comments are acted upon. Although the SEC letter will normally be addressed to the president of the funds, the SEC expects that substantive comments be brought to the attention of the board. The board may delegate this function to the audit committee, which is normally made up of all independent directors.

Perhaps the worst thing that can happen after a comment has been made by an SEC examiner is that the subject is ignored or temporarily fixed, only to return to its former condition shortly thereafter. When the SEC plans its next visit, comments from prior exams are thoroughly review. If a prior deficiency is not corrected, the SEC is typically alarmed as its omission reflects not only poor internal controls but also a careless attitude toward compliance. Of course, ignoring an SEC comment is absolutely damming as afar as defending a lawsuit is concerned.

Quite often the advent of new technology can provide a way for the manager to systematize the correction of a prior deficiency. For example there are excellent new software systems that capture, retain and report departures from a fund's code of ethics, particularly with regard to personal equities trading.

The directors of a mutual fund often find that help in responding to the SEC comments from a specialized attorney is useful. Sometimes counsel to the independent directors plays this role, but if there are specific deficiencies about a detailed topic found, another law firm might be brought to help craft an appropriate response.


In conclusion, the oversight that independent mutual fund directors bring plays a vital part in safeguarding shareholder interest. Their concern and effectiveness is evidences by the way in which a fund prepares for an SEC examination, in the way in which the content of the comment letter is handled and the corrective action taken.

Next >